Appeal Court rules on Arctic Systems test case

‘Husband and wife’ companies are safe from attack under the anti-avoidance ‘settlements’ legislation, the Appeal Court has ruled in the key Arctic Systems test case. Unanimously overthrowing the High Court verdict, the Appeal Court judges dismissed every plank of the Revenue and Customs case.

Geoff and Diana Jones both held shares in Arctic Systems Ltd, an IT consultancy, and received dividends. The High Court had ruled that dividends paid to Mrs Jones should be taxed as part of her husband’s income because it was Mr Jones who generated the company’s income and he drew only a small salary. These factors gave the arrangement an element of bounty, which brought it within the obscure settlements rules.

The Appeal Court said there was no ‘settlement’, firstly because Mrs Jones had paid full value for her shares, and secondly because there was no obligation for Mr Jones to work for a low salary, or indeed to work at all, and no guarantee of profits or dividends. Furthermore, Mrs Jones did contribute to the business, spending around five hours a week on book-keeping, invoicing, etc. Even if Mrs Jones had not paid for her shares, there would be no settlement because a share is not merely a right to income. The settlements provisions cannot extend to a commercial venture of this type between husband and wife.

HMRC was refused leave to appeal to the House of Lords, but will seek leave to appeal direct. In the meantime, HMRC will not update its guidance to taxpayers based on the High Court ruling, but this does not have statutory force. The government could also change the rules by legislation, so watch this year’s Budget.

For the moment, tax planning for family companies has been given a new lease of life, though it is important to take care, as HMRC might try to attack arrangements that differ in some details from those in Arctic Systems. However in many cases, where both spouses own and receive dividends on shares, each should now be taxed on the dividends they receive.

If dividends paid to one spouse were included on the other spouse’s 2004/05 tax return, both returns can now be amended so that each spouse is taxable on their own income on the basis of the Appeal Court verdict. Please contact us if you would like to discuss the implications of this decision on your business.